Chapter 5

Chapter 5: Theory on producer behaviors
February 9, 2022
Chapter 5: Theory on producer behaviors February 9, 2022 1 / 51

Motivation
Figure: Production of pineapple

Motivation
Figure: iPhone supply chain by Apple

Content
1 Theory of production
Production function
Short-run: Production with a variable input
Long-run: Production with two variable inputs
2 Theory of cost
Short-run costs
Long-run costs
Economic cost, accounting cost, sunk cost
3 Theory of profit
Total Revenue, Total Cost and Profit
Profit maximization

Theory of production
Production function
A production function: Function showing the highest output that a firm

can produce for every specified combination of inputs applies to a given
technology.
Given technology is a given state of knowledge about the various methods

that might be used to transform inputs into outputs.
As the technology becomes more advanced and the production function

changes, a firm can obtain more output for a given set of inputs.

Figure: Production function

Production function
Production function is a compact description of how inputs (capital K, L

labor) are turned into output Q.
Q = f(K,L) (1)

Short-run versus Long-run
Short-run production
The short-run production is the production in which one input, labor, is
variable, and the other, capital, is fixed
Long-run production
The long-run production is the production in which both labor and capital
are variable.

Production with one variable input (labour)
Average product of labour (Labour productivity) Output per unit of
labour.
Output Q
APL = = (2)
Labour L
Marginal product of labour: The increase in output that arises from an

additional unit of labour
∆Output ∆Q
MPL = = (3)
∆Labour ∆L
These two definitions are also applied to Capital.

Production with one variable input (labour)

Diminishing marginal product
The marginal product of an input declines as the quantity of the

input increases
Explain: As the number of workers increases, additional workers

have to share equipment and work in more crowded conditions.

Total output, Marginal product and Average product

Total output, Marginal product and Average product
The marginal product is above the average product when the average
product is increasing and below the average product when the average
product is decreasing.
It follows, therefore, that the marginal product must equal the average
product when the average product reaches its maximum. This happens at
point E.

The Law of Diminishing Marginal Returns
Principle that as the use of an input increases with other inputs fixed,
the resulting additions to output will eventually decrease.
The law of diminishing marginal returns describes a declining marginal

product but not necessarily a negative one.
The law of diminishing marginal returns applies to a given production

technology

Is there food crisis?
Political economist Thomas Malthus (1766–1834) believed that the

world’s limited amount of land would not be able to supply enough food as
the population grew.
He predicted that as both the marginal and average productivity of labor

fell and there were more mouths to feed, mass hunger and starvation
would result.

Improvements in technology, despite of diminishing returns
to labor

Cereal yields have increased while the average world price
of food has declined since the 1970s

Production with two variable inputs

Production with two variable inputs
Isoquant
An isoquant is a curve that shows all the possible combinations of inputs
that yield the same output.

Isoquants

Isoquants
Production isoquants show the various combinations of inputs necessary

for the firm to produce a given output.
A set of isoquants, or isoquant map, describes the firm’s production

function. Output increases as we move from isoquant q1 (at which 55
units per year are produced at points such as A and D), to isoquant q2 (75
units per year at points such as B), and to isoquant q3 (90 units per year
at points such as C and E).
Isoquants show the flexibility that firms have when making production
decisions: They can usually obtain a particular output by substituting one
input for another.

Substitution Among Inputs
Marginal rate of technical substitution (MRTS)

Amount by which the quantity of one input can be reduced when one
extra unit of another input is used, so that output remains constant.
MRTS = − Change in capital input/change in labor input

MRTS = −∆K /∆L(for a fixed level of q)


The slope of the isoquant at any point measures the marginal rate of
technical substitution—the ability of the firm to replace capital with labor
while maintaining the same level of output. On isoquant q2, the MRTS
falls from 2 to 1 to 2/3 to 1/3.

Diminishing MRTS
The MRTS falls as moving down along an isoquant. The mathematical

implication is that isoquants, like indifference curves, are convex, or bowed
inward. This is indeed the case for most production technologies.
The diminishing MRTS tells us that the productivity of any one input is
limited. As more and more labor is added to the production process in
place of capital, the productivity of labor falls. Similarly, when more
capital is added in place of labor, the productivity of capital falls.
Production needs a balanced mix of both inputs.

Diminishing MRTS
Additional output from increased use of labor = MPL ∆L
Reduction in output from decreased use of capital = - MPK ∆K
Because we are keeping output constant by moving along an isoquant, the

total change in output must be zero. Thus,
(MPL ∆L) + (MPK ∆K ) = 0
The marginal rate of technical substitution between two inputs is equal to

the ratio of the marginal products of the inputs:
(MPL )/(MPK ) = −(∆K /∆L) = MRTS

Special isoquant: inputs are perfect substitutes

Chatbot vs Livechat in Customer Services

Special isoquant: fixed-proportions production function

Special isoquant: fixed-proportions production function

Theory of cost

Theory of cost
Economic Cost
Cost to a firm of utilizing economic resources in production.
Accounting Cost
Actual expenses plus depreciation charges for capital equipment.
Opportunity cost
Cost associated with opportunities forgone when a firm’s resources are not
put to their best alternative use.

Opportunity cost
Consider a firm that owns a building and therefore pays no rent for
office space. Does this mean the cost of office space is zero?
The firm’s managers and accountant might say yes, but an economist
would disagree. The economist would note that the firm could have
earned rent on the office space by leasing it to another company

Economist vs Accountant: Revenue = Cost + Profit
*What is the implication of Zero Economic Profit?

Total cost, Fixed cost and Variable cost
Total cost (TC or C)

Total economic cost of production, consisting of fixed and variable costs.
TC = FC + VC
Fixed cost (FC)

Cost that does not vary with the level of output and that can be
eliminated only by shutting down.
Variable cost (VC)

Cost that varies as output varies.

Distance between TC and VC is FC

What is the fixed cost of a Pizzeria

Average cost
Average total cost (ATC)

Firm’s total cost divided by its level of output.
TC
ATC =
Q
Average fixed cost (AFC)

Fixed cost divided by the level of output.
FC
AFC =
Q
Average variable cost (AVC)

Variable cost divided by the level of output.
VC
AVC =
Q

Marginal cost
Marginal cost (MC)

Increase in cost resulting from the production of one extra unit of output.
MC is the derivative of TC (and VC) when taking the first

differentiation of TC subject to Q
∆TC
MC = = TC 0 = (VC + FC )0 = VC 0 (becauseFCisfixed)
∆Q
∆VC
MC =
∆Q

Cost in short-run (One variable input: Labour)
MC is the derivative of VC when taking the first differentiation of VC

subject to Q
In short-run: ∆VC = w ∆L
∆VC w ∆L
MC = =
∆Q ∆Q

Diminishing marginal returns and Marginal cost
Recall: Diminishing marginal returns means that the marginal product of

labor declines as the quantity of labor employed increases.
When there are diminishing marginal returns, marginal cost will

increase as output increases.

Shape of cost curves:MC and ATC, AVC, AFC

MC crosses AVC and ATC at their minimum points
Average total cost ATC is the sum of average variable cost AVC and
average fixed cost AFC (vertically).
Marginal cost MC crosses the average variable cost and average total
cost curves at their minimum points.

The ATC curve shows the average total cost of production
Because ATC = AVC + AFC, and AFC curve declines when output
increases, the vertical distance between the ATC and AVC curves
decreases as output increases.
The AVC cost curve reaches its minimum point at a lower output
than the ATC curve
This is because MC = AVC at its minimum point and MC = ATC at its
minimum point.
Because ATC is always greater than AVC and the marginal cost curve MC
is rising, the minimum point of the ATC curve must lie above and to the
right of the minimum point of the AVC curve.

Cost in long-run
The Relationship between Short-Run and Long-Run Average Total

Cost: Case study of car manufacturer Ford Motor Company
Over a period of only a few months, Ford cannot adjust the number or
size of its car factories. The only way it can produce additional cars is to
hire more workers at the factories it already has. The cost of these
factories is, therefore, a fixed cost in the short run. By contrast, over a
period of several years, Ford can expand the size of its factories, build new
factories, or close old ones. The cost of its factories is a variable cost in
the long run.

Long-run vs short-run curves

Long-run vs short-run curves
The long-run average-total-cost curve is a much flatter U-shape than

the short-run average-total cost curve.
In addition, all the short-run curves lie on or above the long-run

curve. These properties arise because firms have greater flexibility in the
long run.
In essence, in the long run, the firm gets to choose which short-run curve
it wants to use. But in the short run, it has to use whatever short-run
curve it has chosen in the past.

Economies and Diseconomies of Scale
Economies of scale
the property whereby long-run average total cost falls as the quantity of
output increases
Diseconomies of scale
the property whereby long-run average total cost rises as the quantity of
output increases
Constant returns to scale

the property whereby long-run average total cost stays the same as the
quantity of output changes

What might cause economies or diseconomies of scale?
Economies of scale
often arise because higher production levels allow specialization among
workers, which permits each worker to become better at a specific task.
For instance, if Ford hires a large number of workers and produces a large
number of cars, it can reduce costs with modern assembly-line production.
Diseconomies of scale
can arise because of coordination problems that are inherent in any
large organization. The more cars Ford produces, the more stretched the
management team becomes, and the less effective the managers become
at keeping costs down.

Does Boeing exhibit economies or diseconomies of scale?
If Boeing produces 9 jets per month, its long-run total cost is $9.0
million per month. If it produces 10 jets per month, its long-run
total cost is $9.5 million per month.

Theory of profit
Profit = Total revenue - Total cost

π = TR − TC
To maximize π, we maximize (TR-TC)
π is maximized when MR = MC
* What are the differences between maximizing profit, maximizing revenue
and minimizing cost?

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Chapter 5: Theory on producer behaviors

Chapter 5: Theory on producer behaviors February 9, 2022 1 / 51

Figure: Production of pineapple

Chapter 5: Theory on producer behaviors February 9, 2022 2 / 51

Figure: iPhone supply chain by Apple

Chapter 5: Theory on producer behaviors February 9, 2022 3 / 51

Chapter 5: Theory on producer behaviors February 9, 2022 4 / 51

A production function: Function showing the highest output that a firm

Given technology is a given state of knowledge about the various methods

As the technology becomes more advanced and the production function

Chapter 5: Theory on producer behaviors February 9, 2022 5 / 51

Figure: Production function

Chapter 5: Theory on producer behaviors February 9, 2022 6 / 51

Production function is a compact description of how inputs (capital K, L

Chapter 5: Theory on producer behaviors February 9, 2022 7 / 51

Chapter 5: Theory on producer behaviors February 9, 2022 8 / 51

Marginal product of labour: The increase in output that arises from an

These two definitions are also applied to Capital.

Chapter 5: Theory on producer behaviors February 9, 2022 10 / 51

The marginal product of an input declines as the quantity of the

Explain: As the number of workers increases, additional workers

Chapter 5: Theory on producer behaviors February 9, 2022 11 / 51

Chapter 5: Theory on producer behaviors February 9, 2022 12 / 51

Chapter 5: Theory on producer behaviors February 9, 2022 13 / 51

The law of diminishing marginal returns describes a declining marginal

The law of diminishing marginal returns applies to a given production

Chapter 5: Theory on producer behaviors February 9, 2022 14 / 51

Political economist Thomas Malthus (1766–1834) believed that the

He predicted that as both the marginal and average productivity of labor

Chapter 5: Theory on producer behaviors February 9, 2022 15 / 51

Chapter 5: Theory on producer behaviors February 9, 2022 16 / 51

Chapter 5: Theory on producer behaviors February 9, 2022 17 / 51

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Production isoquants show the various combinations of inputs necessary

A set of isoquants, or isoquant map, describes the firm’s production

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Marginal rate of technical substitution (MRTS)

MRTS = − Change in capital input/change in labor input

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The MRTS falls as moving down along an isoquant. The mathematical

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Additional output from increased use of labor = MPL ∆L

Reduction in output from decreased use of capital = - MPK ∆K

Because we are keeping output constant by moving along an isoquant, the

The marginal rate of technical substitution between two inputs is equal to

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*What is the implication of Zero Economic Profit?

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Total cost (TC or C)

Fixed cost (FC)

Variable cost (VC)

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